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How Might Peer-to-Peer Investing Do in a Recession?

By: Kevin MercadanteUpdated: November 29, 2017

Seven years into the current economic expansion, speculation is growing that a recession is close at hand. This suspicion is supported by signs of weakening in both retail and restaurants, two leading indicators of consumer demand. Given that peer-to-peer (P2P) investing is only a few years old, now is an outstanding time to contemplate how the sector might perform in a recession.

The Effects of Recessions on Lending in General

In general, recessions tend to cause loans of all types to deteriorate in performance. Job losses tend to lead to higher loan default rates; borrowers default on individual loans or are forced into bankruptcy. Loan portfolios that looked rock solid become increasingly speculative. The damage is even greater if the recession is protracted, as that causes the number of defaults to multiply.

There’s no reason to believe that loans made through peer-to-peer platforms are exempt from the normal business cycle. They are, after all, consumer loans and subject to all the risks consumer lending involves. Economic downturns are one of those risks.

P2P Performance During the Last Recession

One of the biggest problems with peer-to-peer investing is that there’s little performance history from the last recession. The two oldest and largest P2P platforms, Prosper and Lending Club, only started in 2005 and 2006, respectively. The Financial Meltdown hit sometime in 2007, when both were just getting out of the starting gate. Other P2P platforms didn’t start until well after that recession ended.

It’s pure speculation whether peer-to-peer loans will perform better or worse than bank loan portfolios in a recession. But we do have some clues, based on the nature of P2P lending. Three in particular:

1. Most Peer-to-Peer Loans Are Unsecured

During an expanding economy, this may not be a major factor. But in a recession, when loan defaults are increasing, the absence of collateralization of P2P loans might become a serious problem. It means recourse is extremely limited in the event of increasing default levels.

2. The Debt Consolidation Dilemma

Debt consolidation loans are one of the major reasons why borrowers use P2P lenders. They are looking to consolidate several high-interest credit cards into a single unsecured installment loan. That loan will have the benefit of both a lower payment and the ability to pay off the debt within three to five years.

But debt consolidation can have the opposite effect, especially in recessions. Once high interest debt has been consolidated onto a P2P loan, the borrower is then free to use the paid-off credit cards all over again. This can lead the borrower deeper into debt and increase investor risk on P2P debt consolidation loans. But it will happen only after the loan has been made, when the higher risk can’t be calculated into the loan price.

3. Limited Liquidity

One of the inherent limitations of peer-to-peer investing has always been the inability of investors to sell loan notes after investing in them. Once you invest in a note, you must hold it until the loan is paid off. Many P2P platforms have no capacity to allow for early departure from loan portfolios.

Lending Club offers a limited ability to do this through its Note Trading Platform in partnership with FOLIOfn Investments. Prosper offers the service as well through their Folio Investing Note Trader feature.

But this note trading market makes loan notes available for sale only to existing investors on those platforms. The market price of loan notes on the secondary market could fall if the number of existing notes offered for sale were to rise substantially and swamp investor demand. That could happen if declining economic conditions were to cause default rates to rise and P2P investors to liquidate their positions in response.

Meanwhile, analysts have speculated that increased institutional participation in P2P lending might have the dual effect of lowering both interest rates and loan quality as a result of too much money chasing too few loans. A Bloomberg article from 2015 had this to say on that front:

“But as institutions pour money into P2P, some platforms may relax their credit criteria and welcome riskier borrowers to accommodate the flow, especially if they can offload risk through securitizations, says Michael Tarkan, an equities analyst at Compass Point Research & Trading in Washington who covers P2P companies.”

None of this means either Lending Club or the peer-to-peer lending industry is in serious trouble, but it does indicate the honeymoon phase of the industry’s rise may be over, as the realities of consumer lending assert themselves.

Stay With Higher Credit Grades

In recent years, return on investment has been higher when lower grade loans are included in the mix. That’s largely because lower quality loans are less likely to default in an expanding economy. But let’s take a look at how things played out during the last recession.

Lending Club Loan Performance During 2007–2009 Recession

The chart above represents loan performance of Lending Club from the first quarter of 2007 through the fourth quarter of 2009. That’s a three-year period roughly encompassing the Financial Meltdown.

Now, this analysis may not be entirely valid. The chart reflects a platform in its infancy, with a total of $76.5 million dollars in loans issued. Lending Club is now a multi-billion dollar lending facility, which could change the outcome one way or the other.

Note that during this time frame, the lowest grade loans — FG — had a net annual return of just 0.64%. The average interest rate was actually 17.65%. That means loan losses was about 17% of the portfolio! Translation: Nearly 100% of interest income was eaten up by loan defaults.

But in looking at the top of the chart, the highest quality loans, those with an A rating, had the highest net annualized return, at 5.26%. The average interest rate for the group was 8.68%, reflecting loan losses of just 3.42%. This was the lowest default rate of all credit grades.

The moral of the story is yield is not all that matters with P2P lending, especially during economic downturns. A recession — or the prospect of one — should have you favoring higher grade loans.

Why Peer-to-Peer Lending Is Not a High-Yield Substitute for Safe Investments

Finally, as investors chase higher yields, there’s more than a hint that P2P investing is beginning to figure into the safe assets portion of investor portfolios. Is that a wise strategy?

We can only speculate, but I believe it’s too early to answer that question. Until the industry successfully weather’s a recession, it might be better to consider P2P investments as something like high-dividend stocks — they’re safer than growth stocks, but they’re not safe in the strictest sense of the word.

Though they can improve yield on the fixed income side of your portfolio, they don’t represent the counterweight to stocks you get from traditional short-term fixed income investments like Treasury bills and certificates of deposit. Those assets have zero risk of default — the basic and essential purpose of safe investments during difficult times — even if the returns are miserable.

In the meantime, we don’t have enough evidence that P2P investing fills that role. It may not be necessary to bail out of P2P investing at the first sign of a bad economy, but it is necessary to recognize the limits of that asset class, at least at this point in time.

How do you think P2P investing will do in the next recession? What part of your portfolio do they occupy?

P2P investing guru Brendan Ross is here to give us the real story on how to make money like a millionaire. Here's how you could increase your cash flow!

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Steve

1 year 3 months ago

Good review, moral of the pending story! Don’t invest if you can’t afford to lose.

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Fred Fandango

1 year 3 months ago

It is interesting that only F and G grade loans performed poorly. Grades A through D had a similar net performance and E had only slightly lower performance that is likely not significantly different from A through D. This does not support your contention that higher grade loans perform better but it does suggest that one would be wise to avoid the riskiest loans. Indeed, most of the data I have seen supports the idea that the sweet spot for total return is in the middle of the risk range. This could be as true in times of stress as under ordinary conditions. Comments?

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